Can't Sell and Want to Rent: What are the Tax Rules Again?
By Carola Knoll, CPA
With the current instability in the U.S. housing market, many potential sellers are renting their homes. Accordingly, there are several tax rules to be aware of if renting. As with many areas of tax law, knowing and understanding the general rules are equally as important as knowing the exceptions to them.
RENTAL ACTIVITIES ARE PASSIVE
Before the Tax Reform Act of 1986, losses from rental real estate activities and other “passive activities” were allowed to offset “ordinary” income. To stem perceived abuse, that Act created the rules for “passive activities” which defines all rental activities as passive. Why does this matter? Because passive activity losses are only allowed to offset passive activity income, and unless some exceptions are met, you will not be able to deduct your passive rental losses currently if you don’t have passive activity income. Any passive activity losses that are not allowed during the year will carry over to future years until you either have passive income to offset it or completely dispose of the property.
EXCEPTION 1: Passive activities are activities in which a taxpayer does not “materially” participate, so if you are involved in the rental activity on a regular, continuous and substantial basis, and you meet at least one of the various tests for material participation, you may be considered a “real estate professional” and then be able to treat your rental activities as “nonpassive.” Losses from the activity would then be allowed to offset wages, interest and other nonpassive income. The rules for meeting the qualification to be treated as a “real estate professional” are discussed in this issue; however, it is best to consult with your tax advisor to determine if you do qualify.
EXCEPTION 2: Individuals may be eligible to deduct up to $25,000 of rental losses without regard to the passive activity rules if they “actively” participate in their rental real estate activity. That allowance phases out when adjusted gross income (“AGI”) exceeds $100,000 and is completely phased out at $150,000 of AGI. If your filing status is “married filing separately,” you are allowed only half of those amounts. Most individuals who make management decisions for the rental (e.g., approval of tenants, of repairs, of service providers to be hired) will be considered to “actively” participate.
EXCEPTION 3: Your “rental” may not be a “rental activity” if you only rent to short-term tenants. The definition of a rental activity excludes rentals of property if the average period of customer use is seven days or less. There are some additional exceptions, but if your rentals are not “rental activities” as defined, then you are not entitled to the $25,000 allowance for active participation rental activity losses described above. Also, depending on the level of participation, the short-term rentals may be considered passive or nonpassive activities so losses may still be limited under the passive activity rules.
sPERSONAL USE OF RENTAL PROPERTY LIMITS DEDUCTIONS
Generally, if personal use of a home exceeds the greater of 14 days or 10% of the time it’s rented out, the home is not a rental property and the “vacation home” rules limiting deductions will apply. “Vacation home” tax rules limit the deductions according to a ratio that ensures that the rental expenses are limited to rental income.
EXCEPTION 1: If you rent at fair market value for at least 12 consecutive months, the use of the home as your principal residence for any day during a tax year that includes the beginning or end of the rental period is not considered “personal use” for the purpose of applying the vacation home limitations. This rule also applies if the home is sold before it is rented or held for rent for the full 12-month period.
EXCEPTION 2: If the home is a residence of the taxpayer, and it is rented for less than 15 days, neither the rental income is includable in gross income, nor are any of the rental expenses allowed as a deduction. This is a rare exception where you can receive income and not be taxed on it!
© 2011 WithumSmith+Brown, PC
Carola Knoll
5 Vaughn Drive | Princeton, NJ 08540 | 609.520.1188 | cknoll@withum.com